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Monday, March 14, 2011

BusinessWorld Online Edition |The frog prince and OPSF

Introspective -- By Raul V. Fabella

The frog prince and OPSF

The price of Dubai crude shot up to $110.63 per barrel on March 7, 2011, up $11 from where it stood at the beginning of the year. While it is some ways from the $140 a barrel in 2007, the price spike suggests some further upward movement as the Libyan crisis protracts. Oil-importing countries are once more caught in an inflationary vortex and must manage the adverse effects on their economies. The pump price of diesel fuel has breached P43 per liter and average inflation now threatens to breach 4% in the Philippines.

This is a recurring problem, and how to address it is a delicate balancing act. On the one hand, the government must be seen to be doing something; on the other, what it does can permanently cripple the future prospect of the economy. The Philippines is a parable of repeated self-crippling.

The finance department has trial-ballooned the lifting of the 12% VAT on oil and targeted subsidy for the poor. The finance department correctly rejected the lifting of the 12% VAT on oil during the last oil price spike in 2007. The government -- facing a gaping fiscal deficit and increased spending programs -- will do well to do the same. While some programs can be indefinitely postponed (the K-12 program of the Department of Education is very costly, without commensurate foreseeable benefits and will actually impose added burden on households with school-age children), others such as the infrastructure program and the CCT cannot be postponed as they themselves act as social safety nets. Th additional targeted subsidy needs financing. The windfall tariff revenue from rising import bill should be the proper primary financing source.

Many bills filed in Congress display more bluster: repeal the Oil Industry Deregulation Law of 1998 and restore the Oil Price Stabilization Fund (OPSF). Foisted and rejected in 2001 and again in 2007, this avatar refuses to die. Why? The OPSF means to address two market failures: (1) the social cost of the price volatility of the fuel price and (2) the abuse of market power by oil companies, or both. The micro-theoretic argument for price stabilization is compelling: Set the pump price of fuel according to the long-run average price of petroleum, accumulate reserves when the current petroleum price is less than the long-run average, de-cumulate reserves when the current price is higher than the long-run average and the expected balance of the reserve equals the seed fund made available initially. When the conditions are right, the OPSF erases pump price volatility stemming from global petroleum price fluctuations around the mean. It’s the closest you come to value for nothing! In reality, the proper implementation of OPSF requires some very difficult conditions. First, the government has to know the long-run average which involves accurate forecasting of petroleum prices. If this is too low, the OPSF becomes a general pump price subsidy as the fund goes in the red. The government also has to know when there is a regime shift (a rise, say, in the long-run average) and to adjust pump price accordingly. Most crucially, government must have the mettle to stare down political pressure when it’s time to raise the pump price. Given irresolute governance, the OPSF balance quickly goes into the red and becomes a permanent fiscal burden. This is what happened.

The OPSF contributed immensely to semi-permanent Philippine fiscal crisis from 1984 to 1998. The cost of OPSF to the taxpayer in 1998 alone would have been P8b. It subsidized motorists (with more subsidy going to SUV owners) while it bled the budget for infrastructure. Cheap fuel burned over bad roads means longer travel time, more fuel burned, and higher net fuel spending! Do you wonder why our road infrastructure is so bad compared to our regional neighbors?

Behind the OPSF proposal is the usual undercurrent of romance with a nationalized oil industry. Abuse of market power by oil companies is the perennial bogeyman. That the nationalization of the oil industry as a remedy opens the floodgates to misuse of government power is conveniently shelved. That government failure costs society more than market failure is forgotten. Forget "Telepono sa Barangay"; forget the massive overpricing at NFA; forget the water supply interruptions before MWSS was privatized. I shudder at the thought of the orgy of waste and rent-seeking.

It puzzles me how the people who normally castigate the government for failing to count votes properly or run trains properly also believe that the same government can operate, to public benefit, oil price stabilization or a nationalized oil industry. Why will the perennial rogue suddenly turn into a saint? I call it the fallacy of the frog prince: however ugly you are, the kiss of the princess will at once turn you into a handsome prince. The frog is the government and the princess is OPSF or your favorite state intervention! If only life was so simple!

Raul V. Fabella is with the UP School of Economics and the National Academy of Science and Technology.

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FEF is a public advocacy organization dedicated to advancing the cause of economic and political liberty, good governance, secure and well-defined property rights, and market oriented reforms. It counts among its members former and present Cabinet secretaries and undersecretaries, leading figures in the academe, respected media personalities and opinion makers, and prominent members in the business and finance community.